The Veridian Blog

I’m sorry if this sounds a tad like Econ 101, but since this is a  trending topic, I decided to regurgitate my college education.  The Fed – which includes the Board of Governors and the broader Open Market Committee (FOMC), has three major tools at its disposal – they are 1) the Discount Rate, 2) Reserve Requirements and 3) Open Market Operations. 

The Discount Rate is the interest rate charged to commercial banks and other depository institutions when they borrow money from the Fed.  They will lower this rate to increase money supply and add more liquidity by making it cheaper for the banks and/or its consumers to borrow money.  The theory here is that they will, in turn, spend the money, create jobs and thus help the economy grow.  The Fed will raise the Discount Rate in a time of rising prices to curb the onset of inflation.

The Fed can also set requirements for banks to hold a certain amount of reserves in the form of vault cash or deposits with Federal Reserve Banks.  Lowering reserve requirements will increase money supply and put more funds into circulation and vice versa.  This is probably the least used Fed tool. 

And last but not least, the FOMC mostly prefers to buy and sell US Treasury products as a means to affect the Federal Funds Rate (FFR), or what banks charge each other.  Now even though banks are lending money from their Federal Reserve deposit accounts, did you know that the Fed cannot actually change the FFR?  Instead, the FOMC targets a rate that it believes would mean stability and strength for the economy on the whole – and this is what we hear in the news.  Then it engages in open market operations to try and get the actual FFR close to the target rate.  Open market operations are based on the same principle as the other tools:  changing the supply of money.  By selling government securities, the Fed decreases the supply of money available to depository institutions (because it's effectively giving security notes in exchange for cash) — and that, in turn, increases the price of that money — the federal funds rate.  Buying government securities, on the other hand, increases the supply of money available to depository institutions (it's effectively taking security notes in exchange for cash), which, in turn, decreases the price of that money — the federal funds rate.

Confused?  Email me for some fun supply and demand graphs (just kidding, I would never do that to anyone)…